A non-callable 3-year UK government bond pays semi-annual coupons.The face value is 10,000, the annual coupon rate is 10% and the yield to maturity is 16% per year. This bond has an annualised convexity of 7.56.

(a) Show clearly how the current market price and annual modified duration are calculated from the data above. Then discuss how the modified duration may be used to estimate the price change resulting from a 1% change in the annual yield.

(b) Explain what is meant by convexity with regard to the priceyield relationship and how this impacts on your price change estimate in part (a).

(c) Some bonds are issued with embedded options, which impacts the convexity mentioned in part (b) above. Explain this phenomenon with regard to 'call' and 'put' options.